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Aug. 22 — Family-owned automotive dealerships, manufacturing companies and real estate firms
are among the types of entities that may be adversely impacted by IRS rules designed
to curb a tactic used to lower estate taxes.

Private and public family-owned or -controlled companies—from food manufacturer Mars
Inc. to superstores like Wal-Mart Stores Inc.—account for about 90 percent of U.S.
businesses.

The Internal Revenue Service issued proposed regulations (REG-163113-02) Aug. 2 to place limitations on the use of valuation discounts used primarily by
private family businesses. Such discounts reduce the overall value of assets in such
entities, which lowers the estate and gift tax liability for family members with business
interests. They are typically applied to compensate for the lack of marketability
and control that can make assets within those entities harder to sell (149 DTR G-4, 8/3/16).

For years the agency has wanted to crack down on abusive transactions where wealthy
families have applied valuation discounts—which can range from 30 to 40 percent—to
partnerships containing marketable securities such as stocks and bonds that could
be easily valued and sold.

“We can have a reasonable argument about that because certainly there’s been abuse
there, but it seems to be throwing the baby out with the bathwater,”
said William Frazier, an accredited senior appraiser and managing director in the
Valuation and Financial Opinions Group at Stout Risius Ross Inc.

“We’re just kind of surprised that operating companies were hit as hard”
as those types of investment partnerships, said Frazier, who has more than 35 years
of experience in business valuation and corporate finance.

These family-owned entities are getting a great tax benefit, “but the IRS is saying,
‘You’re just recycling dollars. You’re getting the tax benefit and then getting the
valuation done, going through the audit and then liquidating it out to the next generation.'
I’m not seeing that happen,”
Frazier said.

Jobs Lost

According to the
Harvard Business Review, family-owned or -controlled businesses in the U.S. employ 60 percent of workers
and create 78 percent of new jobs.

An operating family-owned business needs valuation discounts because if it was liquidated
“based on its assets you would have a much lower value than you would if you valued
the company on an ongoing basis based on its income,”
Frazier said. That's because those types of interests are typically harder to sell
than they would be if they existed outside of the closely held business, he said.

Under the new rules, appraisers are expected to value family-owned entities based
on what the IRS calls a “minimum value,” which appears to be the fair market value
of the entire enterprise, Frazier said. In many situations that value would be determined
without applying discounts, creating a much higher tax burden for business owners,
he said.

“If there’s going to be an additional 30 or 40 percent tax burden on the shareholders,
on the company, then that money has to come from somewhere, and in most cases it’s
going to reduce their ability to fund their operations,” Frazier said. Cutting jobs
is one way businesses could seek to generate additional revenue, he said.

“We’re not talking about corporate taxes here, but the families basically are the
corporation so you can extrapolate that into a similar type of effect on these businesses,”
Frazier said.

Industries Hardest Hit

Practitioners noted that family-owned auto dealerships, manufacturing companies and
large real estate businesses are among the types of entities that would face the greatest
challenges if the rules were finalized in their current state.

William Raveis, chairman and chief executive officer of William Raveis Real Estate,
Mortgage and Insurance, said the rules would place an extra burden on his ability
to transfer his family business to his two sons.

Even absent the regulations, those kinds of transfers have proven to be a difficult
task for family-owned entities. The
Conway Center for Family Business estimates that while 70 percent of closely held business owners would like to pass
their business on to the next generation, only about 30 percent will actually be successful
in making that transition.

If the IRS rules are in place prior to transferring the business to his sons, Raveis
said, “it almost makes more sense to sell the company and not to transfer it.”

In effect, the proposed regulations have “the ability to destroy a family business,”
said Raveis, whose business was ranked the No. 8 real estate company in the country
by volume in the 2016 REAL Trends 500 survey.

Scott Ditman, a certified public accountant and tax partner at Berdon LLP, said real
estate companies are especially susceptible because they have unique income structures.

Unlike other types of business owners who have an opportunity to take advantage of
discounts now by gifting family entity and limited partnership interests before the
rules become final, “when you have a real estate entity you can’t necessarily just
give stuff away,” Ditman said.

“With real estate the income tax basis of the assets could be significantly lower
than the market value, even negative because in that industry you can depreciate the
real estate and you can refinance and take money out,” he said. People can have what
are called “negative capital accounts”
at times, he added.

If an owner has real estate worth $100 million but a current basis of zero, he or
she won't want to give the property away and risk losing the benefit of a step-up
basis in death where the value of the property is raised to the fair market value
when a beneficiary inherits it.

By using the step-up the beneficiary is only responsible for the capital gains tax
on the appreciation in value that occurs from the point they inherit to the point
when they sell, which provides a huge income tax advantage that would “dwarf what
I'm losing based on the discounts,”
Ditman said.

‘Complete Disconnect.'

Another reason family-owned real estate companies could be vulnerable is because their
public counterparts often trade at a discount, Frazier said.

“Consider the publicly-traded real estate investment trusts that trade in the marketplace,”
he said. A REIT is “a marketable security and most of those trade at a discount in
net asset value,” he said.

“Here the government wants to say if you have a minority interest in your real estate
company, it has to be valued at net asset value despite the fact that all the other
companies out there are trading at discounts,” Frazier said. “That’s a complete disconnect.”

Family-owned manufacturing companies should also be wary of the new IRS guidance,
Frazier said.

“It certainly hits the manufacturing sector hard because companies in that sector
don’t have to have that many employees to have a value that can be reached by these
regulations,” he said. “Let’s say you have a husband and wife. They founded the business
so they have the $10 million-plus lifetime exemption. Companies that have a value
below that aren’t going to get hit by this, but companies that have a value above
that will.”

And it doesn't take much to have a manufacturing business that passes the $10.9 million
estate tax exemption threshold—a conservative number because many families may have
already used part of their exemption—for married couples, according to Frazier.

“That's a lot of companies, tens of thousands of companies that will be affected,”
he said. At the same time, smaller manufacturing firms are a group least likely to
be prepared for the impact of the proposed regulations and to have adequate resources
to pay the additional tax burden, Frazier said.

Public vs. Private

Dennis Belcher, a partner at McGuireWoods LLP, noted that while private companies
are more likely to feel the effects of the new regulations, public companies could
also take a blow.

“Many clients that have large controlling interests in public companies will want
to keep the block together and not let it dissipate. So what they will do is take
the stock from a public company and put it in a limited liability company, and place
the restrictions on the limited liability company’s interests,” he said. That's one
way they could be impacted, he added.

It is unclear how many family-controlled public companies would fall under the definition
of control put forth in the proposed regulations, but it seems to be very broad, Frazier
said.

Under the rules, control is equal to 50 percent or more of the share ownership or
the ability to liquidate the entity in whole or in part, Frazier said.

“Some of the publicly owned corporations have voting and nonvoting stock. The family
owns the voting stock and the public owns the nonvoting stock—for the most part—so
in some of these companies the family has the ability to liquidate the company if
they all voted together in one block,” he said.

While liquidation in that scenario wouldn't make sense, “if you were to value the
company based on shares outstanding, and assuming you were selling the company to
a competitor, that increase in value is something that’s going to” result in additional
taxes, he said.

In those circumstances, shares included in that controlled block could be taxed under
the proposed regulations, Frazier said.

Incentive to Bail

One of the main ways the regulations limit the use of discounts is by ignoring restrictions
that would normally qualify a company to take them.

According to the regulations, a “disregarded restriction” includes one that limits
the liquidation proceeds of an owner to an amount less than a minimum value, which
is defined as net asset value.

An exception applies if each holder of an interest in the entity has an enforceable
“put”
right to receive—on liquidation or redemption of the interest—cash or property with
a value that is equal to at least the defined minimum.

No real operating business would provide that type of put option because it would
incentivize interest holders to “bail,” said Richard Dees, a partner at McDermott
Will and Emery LLP.

“Right now there’s an incentive for people to stay in the business; not to bail out
because they can’t get the full value of the underlying asset. All they can get is
what it is worth to a third party in terms of its market value,” he said.

“But if you give people a put option then their incentive is to run with the cash”
because they can get at least the net asset value of the interest—which it normally
wouldn't be worth—“and not have to worry about the risks that go on with operating
the business,” Dees said.

For example, a child with a 10 percent interest, who doesn't want to continue to run
the business, could force his or her parents to buy the interest back, he said.

“No business can operate with the idea that somebody can bail whenever they want to
at the underlying liquidation value of the business,” he said. “That just says, ‘We
don’t want family businesses to continue. We want them to liquidate or sell out.’ ”

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